(FORTUNE Magazine) – Reed Hastings, who co-founded the DVD-rental outfit Netflix in 1997, has long been portrayed as the innovative but doomed underdog. At first people scoffed at the idea that consumers would want to get DVDs by mail. Then, when Wal-Mart and Blockbuster entered the market, many predicted that the big chains would run tiny Netflix into the ground. Guess not: Blockbuster is recovering from a messy boardroom battle, and in late May, Wal-Mart announced that it was handing over its business to No. 1 player Netflix. Hastings, 44, chatted with FORTUNE's Julie Schlosser recently about working with Wal-Mart, the prediction that video-on-demand will be the real Netflix slayer, and how he picked an Academy Award winner.

How did the deal with Wal-Mart come about?

Over the past year we noticed that its promotional effort had been fairly modest. But the trigger specifically was when I was doing my Christmas shopping. I was out buying DVDs as gifts and noticed how low Wal-Mart's prices were. So I called the CEO in January and asked if he could have dinner.

You just called up Lee Scott?

No. It was John Fleming, the CEO of Walmart.com. I don't think Lee Scott would return my call. Well, not yet anyway. Maybe someday. So we had dinner and started talking about how we could work together.

Any advice about how to beat Wal-Mart?

I'd love to say we--the valiant warriors--won and do a victory dance, but it is more that Wal-Mart decided not to invest very heavily in online rentals. That's a contrast to Blockbuster.

How serious a competitor is Blockbuster?

It's spending more than $100 million and has not turned profitable. It has around one million subscribers. We have three million. When you think about the barriers to entry to this business, it is subtle because it appears easy. A kid can open a website. But the barriers to profitability are very large.

Are you trying to send that message to Amazon, which has launched a British rental service and is rumored to be starting one in the U.S.?

Amazon is pretty savvy about these things. It doesn't need me as a message conduit. I think it is an important message for investors, though. Again, opening a website that does rental is easy. What's hard is [creating] the scale to be able to do it profitably.

Do DVDs have a limited life span, given that video-on-demand (VOD) technology is already available?

Everyone wants to talk about downloading, but I think it'll be a fairly modest effort because of the studios. When consumers buy a DVD, they pay Wal-Mart $18, and $15 goes to the studio. When a consumer downloads [a movie], he pays three or four bucks, and the studio gets a buck or two. So the secret in the movie industry is that DVD--not VOD--is king. I see DVD continuing to grow, and VOD continuing to lag. But not necessarily because of technology. It is sort of like Random House or Simon & Schuster. They emphasize hardcover books first and then paperback. The DVD is the hardcover phase of the market.

But isn't Netflix developing a download service?

We'll launch something very modest this year. We'll spend 1% to 2% of revenues perpetually so that when the market shifts--which will happen eventually--we have a leadership position.

Are you going to start making movies?

Yes. Well, not quite making movies. Last year our staff saw the documentary Born Into Brothels, and we thought it was interesting. No studio would touch it. So we said, okay, we'll give them some money. We'll get it on DVD. Then it went on to win an Oscar for best documentary. It's the first time anyone has ever had an exclusive on an Oscar-winning film in the history of retailing. We got lucky. ■